Fearing JapanPerspective on the News
Monday, June 04, 2012Ed DeShields

An unexpected call went out this week from private wealth managers who manage money for the unusually wealthy. The message? Forget Greece and the euro – they’re finished. Quietly look east and purchase at least one percent of your net worth buying all the derivative default insurance contracts you can buy – on Japan!

“Why? Because you’re gonna need it”, said one manager I met with last week.

When bad economic things are about to happen it’s usually the rich and powerful that get the word first. At first hint of trouble they hedge for losses by placing counter trades that offset the potential for a loss of their wealth. That’s how smart people protect their wealth during a crisis.

This week’s call was as strong a rush to cover as I’ve seen lately. While everyone is hand wringing over Europe suddenly the real sovereign worry turns out to be Japan, the world’s fourth largest economy. In all the news about Europe, Japan has gotten lost in the fog of the news cycle.

Japan’s problems have been around for at least a decade as they struggle through a no-growth deflationary cycle much like the U.S. economy of today. But, something’s up.

It was just last Spring that I sat with Paul Krugman, the Nobel laureate, who casually assured a small audience (including me) that Japan could go on for decades with its low interest, no inflation malaise. Nothing to worry about, he said. Even the U.S. was likely to follow Japan’s economic path given its ballooning debt and low interest rates until we worked out our economic woes.

So why the sudden alarm bells?

Japanese government debt now looks to be beyond the tipping point; 10+ years of kicking the can down the road following the burst of the Japanese bubbles of 1989 has taken its debt from 226% of its GDP to a staggering 512%. And, traders are sniffing something could break. Just a small nudge could tip the pickle barrel.

At the same time multiple demographic and economic problems are amplifying the problem: slow world growth, persistent deflation, and a shrinking Japanese population that are retiring.

Highest among the concerns are the Fukushima Number 4 nuclear plant damaged in last year’s tsunami. Fears are growing that grave structural weaknesses might collapse it into its 1,500 spare fuel rods setting off a catastrophic lake of fire sixty times more destructive than Chernobyl. It didn’t help when Japan’s Prime Minister recently revealed that he was just hours from “the wholesale evacuation of Tokyo”, but stopped short knowing that such a declaration would permanently destroy his nation as its people scattered the world over.

Officials say that a significant earthquake could set off a chain reaction and that it would take at least three years to remove the fuel rods. Seismologists say there is a 96% chance a damage-causing quake will occur at the site in the next three years.

Traders appear to be reaching that magic moment when the market no longer believes this crisis can be averted – that somehow it will miraculously work itself out – triggering a significant devaluation of the Yen and the increase in Japan’s borrowing cost.

Hence, the call to safety by hedge funds and wealth managers by buying insurance that pays off if (or, when) Japan starts to implode.

Unfortunately when Japan goes its takes everyone with them.

One of the key technical factors that Japan’s fortunes may be reversing is that foreigner’s have suddenly appeared to soak up Japan’s debt issuances it needs to pay its bills. Historically, the Japanese could borrow from savings from its own population. They didn’t need foreign money. But even as notorious as Japanese consumers are for saving they cannot save their way out of the government’s need to spend.

Thus the grim prediction; rising interest rates on its debt and the destruction of its currency is likely. So the bet is on for Japan’s failure as the financial markets look for its next victim.